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Share Slump and Credit Crunch: Passing Peak Oil

17

Aug

Share Slump and Credit Crunch: Passing Peak Oil

Submitted by Phil

Regular readers may be surprised to see me offer commentary on the financial markets, given my dim view of such factories of speculation and greed. This is no sideshow, however. The unfolding turmoil may eventually be seen as a historic event. Another turning point, the worldwide peak in oil production, is a key player in this unfolding drama, although its role goes unnoticed by most in the audience.

The Die is Cast

In the wake of the dot-com crash in 2000 and 11th September 2001, the US Federal Reserve began reducing interest rates to stimulate a weak economy. Between 2001 and 2004, interest rates were cut from above 6% to effectively zero. Debt became cheap.

But in 2004, the booming Asian economies pushed world oil demand up noticeably. The days of spare oil capacity in the Middle East were suddenly all but over, and oil prices headed up sharply. The Federal Reserve began to steadily raise interest rates; conventional medicine for the resulting inflation. That started the vicious cycle that is now beginning to unwind in a very unhappy fashion:

Oil Prices Up – Inflation Up – Interest Rates Up

The natural result of this inflationary environment would have been:

House Prices Down – Construction Down – Consumer Spending Down

Housing construction was the main growth activity feeding the US and the world economy, so nobody was particularly interested in seeing a slowdown. The banks decided to feed the housing bubble they had created, so they lowered lending standards to create extra demand for new houses.

Liar Loans

So began an era of sub-prime or low-documentation loans. At their worst, these are rightly called 'liar loans' or NINJA loans – No Income, No Job and No Assets. In what can only be described as a collective act of negligence, many of these loans were provided as so called 'adjustable rate mortgages' (ARMs). Throwing any measure of remaining prudence out the window, the banks were encouraging sub-prime borrowers to take on loans by offering them with low teaser rates, which reset to the commercial rate after two years. This farce may have lasted somewhat longer, but real interest rates were beginning a steady climb – fed by the oil price and inflation cycle.

When the time came for their adjustable rate mortgages to reset to the higher rates, borrowers who were already stretched to maximum found their monthly repayments sometimes doubling overnight. The housing bubble began to collapse as borrowers defaulted on their loans. Banks foreclosed and offloaded the houses sending housing prices into a downward spiral. Although this mortgage crisis has been unfolding for some time, the peak period for resetting of adjustable rate loans is not until the first quarter of next year. The housing market in the US has further to fall.

Lenders and Leverage

The housing market is only one half of the unfolding credit crunch. The lenders who provided the loans sold them onto other investment banks. The cash they earned from the sale allowed them to provide another loan, and then another, and then another. The investment banks who bought the sub-prime loans, packaged them up and sold them on again to other financial institutions. There they were included in all sorts of funds, but the 'sub-prime' tag was often replaced with a AAA endorsement by the credit rating agencies. These are the so called collateralized debt obligations (CDOs) which the financial system has been gorging itself on these last few years.

Many of those clever economists have been quick to point out that although US sub-prime housing may account for a few hundred billion dollars of bad debts, it's small beer in the global economy. The reason it's bringing the financial system to its knees comes down to leverage: bundles of fuzzy assets in CDOs have been used to back highly leveraged purchases of perhaps 100 times as much credit to finance the private equity and other deals, which have been feeding the stock market boom. The problem is compounded by the difficulty in pricing the value of the complex CDOs. When the owners got the jitters and tried to sell, they found their value had been marked down, thus the large drops in value announced by many hedge funds and others.

The banks all want to call in the money they have loaned to others, but know that the same request made of them will force them to sell their assets at mark-down prices. This tense stalemate has been building for some time.

Quoting Jerome a Paris: "The above (left) is the price of corporate loans in the secondary market - i.e. on the market where banks trade IOUs from corporations. If you have a contract that says that a company owes you 100, you can usually sell it (to other banks or financial investors) for 100 or thereabout - a bit more if the buyer thinks the interest rate on the loan is really good, or a bit less if it thinks the interest rate is not quite enough to cover the risk that the company might go bankrupt before paying its debt back.

As you can see above, the price of an IOU of 100 dropped brutally this month from 100 to 95 in the US (and to 97 in Europe). This is the lowest level ever for that market, and an unprecedented drop. This is a credit crunch."

Reassessing Risk

Now the whole house of cards is looking very shaky and the credit market has broken. The normally vibrant flow of money (credit) between different actors in the financial system has suddenly ground to a halt.

Lenders who have for the last few years almost ignored risk, now fear it everywhere. They have priced this new heightened risk by increasing the interest rates on their loans, making them unaffordable. The rapid flow of credit that financed the share market boom has dried up and funds of all types and sizes realise that their value is a lot less than they have been reporting. The few that are forced to own up get savaged by the market, triggering panic across the board. Nobody knows who will be next. Most are trying to swim with one arm and hold their pants on with the other.

The frozen credit market threatens the economy by increasing the cost of financing for real projects and investment. US housing construction is diving and consumer spending is beginning to fall under the weight of sustained high oil prices and mortgage payments (for those that can still afford them). Paper assets have now plummeted in value, and interest rates on all forms of debt may increase. Discretionary spending is likely to fall further, taking the wind out of the sails of the US consumer economy.

Who Sank the Boat

The barrel was loaded by greed; the belief that an economy could be sustained by growing debt. The fuse was lit by rising oil prices, in a world where supply could not match an economy that knew only how to expand.

The markets have managed to shrug off other significant scares over the last two years, but this time it looks to have gone too far. A recession in the US now seems inevitable, the effects of which will perhaps only slowly trickle around the world economy. A slowdown will helpfully reduce oil demand, taking the pressure off oil prices in the absence of other supply disruptions.

Eventually, the financial markets will pull themselves together again and the economy will turn itself around. Only then will we realise that peak oil was passed and there is no going back.